Personal Liability

It is not uncommon for a small or new business owner to operate as a sole proprietorship, which means that both they and their business are one and the same.  Unfortunately, this arrangement can often lead to some very big headaches down the road for an owner, particularly when it comes to covering the business’s debts and liabilities.  It is for this reason that most owners elect to operate as some sort of entity – usually as a corporation or as a limited liability company.  In fact, the primary purpose of incorporating or forming a limited liability company in the first place is insulation from unlimited liability.

For the most part, incorporating or forming a limited liability company shields the individual assets of members and shareholders from creditors.  That is, while creditors are able to reach the assets of the entity itself, once those assets have been exhausted, the personal assets of the entity’s shareholders or members can’t be touched.  That being said, creating a separate business entity does not always provide 100 percent immunity from personal liability.  There are a number of situations where someone could be on the hook for what happens to their business.

“Piercing the Corporate Veil”

Under the right set of circumstances, courts will occasionally “pierce” through an entity to get to the personal assets of its individual shareholders, members or directors.  This is known as “piercing the corporate veil”, and is reserved for situations where a court determines that the entity has been operating as a dummy or sham. 

Piercing the corporate veil is a very complicated topic, and an in-depth analysis is far beyond the scope of this article.  Nonetheless, it is important to know the basic idea behind it to avoid personal liability should your business ever find itself on the wrong side of a judgment.

When deciding the appropriateness of piercing the corporate veil, Illinois courts use a two-part test.  First, a court will analyze if there is “unity of interest and ownership”.  Secondly, a court will determine whether it would “promote injustice or inequity” to allow the entity to exist separately from the individual(s).

            Under the first prong, a court will determine whether separate personalities for the entity and individual(s) exist.  To do this, a court will examine many factors, including whether: (1) the entity was adequately capitalized, (2) stock was ever issued, (3) “corporate” formalities were observed (things like annual meetings and keeping minutes of those meetings), (4) dividends or distributions were ever paid, (5) the entity was insolvent, (6) officers, managers and/or directors actually performed their corporate duties, (7) records were kept, (8) individual funds were comingled with funds of the entity, (9) funds were diverted from the entity at the expense of creditors, (10) there were arm’s length transactions between related entities, and (11) the entity was a mere façade for the dominant owner.

A court may look beyond these factors.  And, no single factor is more important than any of the others – instead, it’s a totality of the circumstances test.  As a matter of practice, it is always a good idea for business owners to check up on their operations just to make sure that they are not violating any of these guidelines.

            Under the second prong of Illinois’ piercing the corporate veil test, a court is going to ask whether there is some inherent unfairness - such as fraud or deception - or if there is a compelling public interest to justify piercing.  In layman’s terms, it basically comes down to whether the situation seems fishy to a court.  Common examples involved thinly capitalized entities, especially where there’s just one owner.  Naturally, there are other scenarios that would fit the bill as well.  It all comes down to the specific circumstances of each entity.

Non-Judicial Ways Creditors Can Get to Your Personal Assets

In addition to veil-piercing, there are other situations where a shareholder or member can be personally liable to an entity’s creditors.  These can be traps for the unwary, so all business owners should be taking notes.

Use of Personal Credit Cards.  This occurs more frequently in small businesses than in large ones, as personal and business expenses often crisscross for small business owners.  Using a personal credit card to purchase office supplies or materials may not seem dangerous on its face, but doing so can lead to personal liability for the balance – and this can be the case even when the business’ name is on the credit card!  It’s never a bad idea to review the terms of the credit application that was originally signed on behalf of an entity.

Signing Documents in a Personal Capacity.  From time to time, an owner or officer will be asked to sign documents in their official capacity on behalf of an entity.   Any business owner or officer who wants to keep themselves out of hot water would be wise to use a “corporate signature” on documents that do not specify that a signature is on behalf of the entity.  We’ve seen too many examples of people singing in a way that can be construed to create personal liability.  By way of example, here’s an illustration of a “corporate signature”:

____________________________

Acme Corporation

By: John Doe

Its: President

Of course, there are other variations than my version, but the most important thing is that any such signature include the name of the signor, the entity, and the signor’s title in relation to the entity. 

Making Personal Guaranties.  Most banks require personal guaranties when giving out loans businesses.  In our experience, only the largest and most credit worthy companies can obtain such “non-recourse debt.”  So just be aware that, as a guarantor, your personal assets will be up for grabs if the entity fails to repay the loan.

            Committing a Crime or Misrepresentation.  This may seem like a no-brainer, but if a person breaks the law, they can’t hide behind their entity for protection.  Similarly, if a person applied for a loan for the entity and lied about the details, they will most likely be personally liable for the fraudulently procured debt.

            The bottom line here is that any business owner seeking to avoid personal liability can’t just incorporate or create a limited liability company and then throw caution to the wind.  If you believe that your business meets any of these criteria, contact your legal counsel for advice.  It’s much better to be prepared now than to face possible personal liability later.